Publications

(Article from Securities Law Alert, Year in Review 2021) 

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Delaware Supreme Court: Plaintiff Need Not Explain Strategy in Section 220 Document Demand

On December 10, 2020, the Delaware Supreme Court held that when a Section 220 books and records inspection demand states a proper investigatory purpose it need not identify the particular course of action the stockholder will take if the books and records confirm the stockholder’s suspicion of wrongdoing. AmerisourceBergen v. Leb. Cnty. Emps.’ Ret. Fund, 243 A.3d 417 (Del. 2020) (Traynor, J.). The court further held that, although the actionability of wrongdoing can be a relevant factor to consider when assessing the legitimacy of a stockholder’s stated purpose, an investigating stockholder is not required in all cases to establish that the wrongdoing under investigation is actionable.

Reaffirming the credible basis test as the standard for investigative inspections under Section 220, the court held that “[t]o obtain books and records, a stockholder must show, by a preponderance of the evidence, a credible basis from which the Court of Chancery can infer there is possible mismanagement or wrongdoing warranting further investigation.” The court determined that when a stockholder can present a credible basis from which a court can infer possible wrongdoing or mismanagement, a stockholder’s purpose will be deemed proper under Delaware law. However, the court cautioned that “a corporation may challenge the bona fides of a stockholder’s stated purpose and present evidence from which the court can infer that the stockholder’s stated purpose is not its actual purpose.” Further, the court explained that “when assessing the propriety of a stockholder’s purpose,” the court can imply “what the stockholders’ intended use of the books and records will be.”

Delaware Supreme Court: Post-Merger Standing Exists if Merger Fairness Is Challenged Due to Failure to Secure a Pending Derivative Claim’s Value

On January 22, 2021, the Delaware Supreme Court reversed the Court of Chancery’s dismissal, due to lack of standing, of post-merger claims challenging a merger’s fairness for the controller’s failure to recoup the value of derivative claims. Morris v. Spectra Energy, 246 A.3d 121 (Del. 2021) (Seitz, C.J.). The court explained that “[w]ith limited exceptions, a merger extinguishes an equity owner’s standing to pursue a derivative claim against the target entity’s directors or controller.” However, the court held that “the same plaintiff has standing to pursue a post-closing suit if they challenge the validity of the merger itself as unfair because the controller failed to secure the value of a material asset— like derivative claims that pass to the acquirer in the merger.”

Referring to the three-part test[1] to evaluate standing on a motion to dismiss in In re Primedia, Inc. Shareholders Litigation, 67 A.3d 455 (Del. Ch. 2013), the court stated that there were “two errors in the [lower] court’s materiality analysis at the motion to dismiss stage of the proceedings.” The court stated that it was reasonably conceivable both that the general partner acted in subjective bad faith and that had plaintiff succeeded in the derivative suit challenging the reverse drop down transaction, the recovery could have been at least $660 million. The court concluded that “[a]pplying a further litigation risk discount at the pleading stage was inconsistent with the court’s standard of review on a motion to dismiss for lack of standing.”

The second materiality analysis error was that “even if it was proper to discount the $660 million in damages alleged in the complaint to reflect the public unitholders’ interest in the derivative recovery, to maintain equivalence, the court should have compared the $112 million pro rata interest in the derivative claim recovery to the public unitholders’ proportional interest in the merger consideration.” The court explained that the merger consideration was $3.3 billion, the public unitholders had a 17% beneficial interest in the merger consideration and that an “apples-to-apples comparison would have compared $112 million to $561 million[ ]” (i.e., 17% of $3.3 billion). The court determined that “[u]nder this calculation, the derivative claim was material at the motion to dismiss stage.”

Delaware Supreme Court: In Overruling Gentile v. Rossette the Court Throws Out the Exception to Tooley’s “Simple” Test to Distinguish Between Direct and Derivative Claims

On September 20, 2021, the Delaware Supreme Court in a unanimous decision overruled Gentile v. Rossette, 906 A.2d 91 (Del. 2006) reversing a Court of Chancery decision that held that plaintiff stockholders had direct standing to challenge a green energy company’s private placement of common stock for allegedly inadequate consideration. Brookfield Asset Mgmt. v. Rosson, 261 A.3d 1251 (Del. 2021) (Valihura, J.). Plaintiffs alleged that the private placement harmed the energy company because the shares were issued at an unfairly low price and allegedly diluted plaintiffs’ economic and voting power. The court agreed with defendants that there was a clear conflict between Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031 (Del. 2004), which established the test to distinguish direct claims from derivative claims, and Gentile, which served as an exception to Tooley. In support of its decision, the court noted the difficulty that courts have had in applying Gentile in a logically consistent way.

Under Tooley, whether a stockholder’s claim is direct or derivative turns solely on: “(1) who suffered the alleged harm (the corporation or the stockholders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually)?” Two years later, the Gentile[2] court allowed minority stockholder plaintiffs to proceed with direct claims and held that “a dual-natured claim arises where: (1) a stockholder having a majority or effective control causes the corporation to issue ‘excessive’ shares of its stock in exchange for assets of the controlling stockholder that have a lesser value; and (2) the exchange causes an increase in the percentage of the outstanding shares owned by the controlling shareholder, and a corresponding decrease in the share percentage owned by the public (minority) shareholders.” A “dual-natured claim” is one that is both derivative and direct in character.

Agreeing with defendants that Gentile imposes confusion on Tooley’s straightforward and easy-to-apply analysis, the court held that the “claim is derivative because [plaintiffs] allege an overpayment (or over-issuance) of shares to the controlling stockholder constituting harm to the corporation for which it has a claim to compel the restoration of the value of the overpayment. Clearly, the gravamen of the Complaint is that the Private Placement was unfair and that [the energy company] suffered harm.”

The court concluded that “the harm to the stockholders was not independent of the harm to the Company, but rather flowed indirectly to them in proportion to, and via their shares in, [the company].” The court stated that this alleged corporate overpayment falls “neatly” into Tooley’s derivative category. The court also observed that it saw “no practical need for the Gentile carve-out.”

Delaware Supreme Court: Adopts Three-Part Demand Futility Test; Agrees That Exculpated Claims Do Not Excuse Demand as They Do Not Expose Directors to a Substantial Likelihood of Liability

On September 23, 2021, the Delaware Supreme Court affirmed a decision dismissing a derivative complaint for failing to make a demand on the board of a social media company under Court of Chancery Rule 23.1. UFCW Union & Participating Food Indus. Emps. Tri-State Pension Fund v. Zuckerberg, 2021 WL 4344361 (Del. 2021) (Montgomery-Reeves, J.). Notably, the court adopted the Court of Chancery’s three-part test for demand futility blending the tests from Aronson v. Lewis, 473 A.2d 805 (Del. 1984),[3] and Rales v. Blasband, 634 A.2d 927 (Del. 1993).[4] Agreeing with the lower court, the court held that exculpated care claims do not excuse demand under Aronson’s second prong because they do not expose directors to a substantial likelihood of liability. The court also determined that plaintiff did not plead with particularity that a majority of the demand board lacked independence.

The court pointed out that the company’s charter contained a Section 102(b)(7)[5] clause, therefore, the directors faced no risk of personal liability from plaintiff’s allegations. Under these circumstances the issue was whether a derivative plaintiff can rely on exculpated care violations to establish that demand was futile under Aronson’s second prong. The court affirmed the Court of Chancery’s holding that exculpated care claims do not satisfy Aronson’s second prong. The court explained that when Aronson was decided rebutting the business judgment rule through allegations of duty of care violations exposed directors to a substantial likelihood of liability and raised doubt as to whether they could impartially consider demand. However, due to the enactment of Section 102(b)(7) and other corporate law developments since Aronson, exculpated breach of care claims no longer pose a threat that neutralizes director discretion.

Going forward, under the refined test, “courts should ask the following three questions on a director-by-director basis when evaluating allegations of demand futility: (i) whether the director received a material personal benefit from the alleged misconduct that is the subject of the litigation demand; (ii) whether the director faces a substantial likelihood of liability on any of the claims that would be the subject of the litigation demand; and (iii) whether the director lacks independence from someone who received a material personal benefit from the alleged misconduct that would be the subject of the litigation demand or who would face a substantial likelihood of liability on any of the claims that are the subject of the litigation demand.” “If the answer to any of the questions is ‘yes’ for at least half of the members of the demand board, then demand is excused as futile.”

As to the impact of the refined test, the court stated that “because the three-part test is consistent with and enhances Aronson, Rales, and their progeny, the Court need not overrule Aronson to adopt this refined test, and cases properly construing Aronson, Rales, and their progeny remain good law.”